Langlois and the Vanishing Hand

Richard Langlois has been guest blogging over at Organizations and Markets, a great blog that focuses on recent developments in academic thinking in economics and management. Langlois, a Professor of Economics at the University of Connecticut, is one of my favorite economists because has been fighting for years to drag economics out of its obsession with static equilibrium models and re-focus it on the dynamic processes that are the source of value (and wealth) creation.

. . . the rationale for the theory of the firm is what we might legitimately call a strategic, entrepreneurial, or Schumpeterian theory of vertical integration. The superiority of centralized control of capabilities lies in the ability to redeploy these capabilities in the service of an entrepreneurial opportunity when such redeployment would otherwise be costly. The firm overcomes the ‘dynamic’ transaction costs of economic change. It is in this sense that we may say the firm solves a coordination problem: it enables complementary input-holders to agree on the basic nature of the system of production and distribution of the product. It provides the structure in a situation of structural uncertainty.

. . . the superiority of the firm rested on its ability to cheaply redeploy, coordinate, and create necessary capabilities in a situation in which (1) the entrepreneurial opportunity involved required systemic change and (2) the necessary new capabilities were not cheaply available from an existing decentralized or market network. In situations, however in which one or both of these conditions is missing, the benefits of the firm are attenuated, and its rationale slips away.

In a recent blog posting, Langlois pointed to his new book The Dynamics of Industrial Capitalism: Schumpeter, Chandler, and the New Economy that will be coming out shortly – for a limited time, the full text of the book is available online here. In this book, especially in Chapters 4 and 5, Langlois develops the theme of the historical transition from the Invisible Hand to the Visible Hand and now to the Vanishing Hand. More concretely, he sets out to try to explain why the large integrated firm described by Alfred Chandler emerged in the late nineteenth century but, more importantly, why the large integrated firm began to unravel in the late twentieth century. As he puts it, “vertical disintegration and specialization is perhaps the most significant organizational development of the 1990s. My goal is to explain this development . . . “

His book covers a lot of ground, including an interesting discussion of Joseph Schumpeter’s theory of the firm, thoughts on the co-evolution of technology and organization, a discussion of the importance of modular systems in improving access to distributed capabilities, and a section entitled from “Friedrich Hayek to Nicolas Hayek”, a great historical view of the evolution of the Swiss watch industry.

A blog posting cannot possibly do justice to the richness of his argument but, in essence, to explain the current trend towards unbundling of business activity, Langlois points to the combination of another wave of technology innovation that reduces economies of scale, the emergence of “thicker” markets (broader reach, richness of interactions and affluence of customers) and the increasing ability of modular systems to take over the function of buffering economic activity from the inevitable uncertainty of markets.

These factors are all important, but two other factors that may be implicit in the notion of thicker markets ought to be given more prominence. First, a global public policy shift playing out over the past fifty or more years has progressively removed barriers to entry and barriers to movement, leading to intensified competition and growing pressure to accelerate capability building. Second, information technology has also given customers much greater ability to evaluate, monitor and switch among vendors, increasing their relative power in markets and leading to what I have characterized as “reverse markets”.

This book served as a catalyst for me to think more historically about the unbundling of the corporation that I began describing almost a decade ago. I have been less focused than Langlois on vertical disintegration and more interested in the unbundling of three businesses that today are tightly integrated within most firms – infrastructure management businesses, product innovation and commercialization businesses and customer relationship management businesses.

As I have noted before, this unbundling is occurring in two broad waves, although the timing and exact nature of the unbundling process differs across industries. In the first wave, infrastructure management businesses – high volume, routine processing activities like assembly line manufacturing, logistics network management and certain types of call center operations – are being systematically carved out of large enterprises and taken over by highly focused and specialized companies. These are precisely the kind of activities that led to the rise of the large, integrated firm in the first place - they are the high fixed cost, high throughput systems that Alfred Chandler described in his historical studies. Much of Langlois’s analysis seems to be focused on this type of carve out.

But another wave of unbundling is at an even earlier stage of playing out. This is the separation of product innovation and commercialization businesses from customer relationship businesses. Of course, at some level, the emergence of traditional retailing could be viewed as an early example of separation of customer relationship businesses from product businesses. Langlois has some interesting observations about the role of generalist merchants in early nineteenth century America who provided loose coupling within the market economy.

But if you look closely at most traditional bricks and mortar retailing businesses, they actually resemble infrastructure management businesses with high fixed costs where throughput becomes the driving consideration. If you doubt that, look at how retailers typically measure profitability and performance – sales and margin generated per square foot of retail space. Life time value of customers – the hallmark of focused customer relationship businesses – is only gradually beginning to draw the attention of retailers. Most retailers are only peripherally customer relationship businesses.

Customer relationship businesses develop deep knowledge of individual customers and use that knowledge to become more and more helpful in configuring the appropriate bundle of products and services for the customer. Personal physicians, personal financial advisors and personal shoppers are all early examples of this kind of focused business. In the past, these businesses largely served affluent customers because only these customers could justify the investment required to build a detailed understanding of individual customer needs.

Chandler makes the case that development of new technologies, especially communication and shipping technologies, helped to catalyze the development of the large, integrated firm in the late nineteenth century. A similar wave of technology innovation will accelerate the next wave of unbundling of product and customer businesses. On one side are the technologies that help to capture detailed profiles of customer behavior and to mine that data to become more helpful in terms of advice. On the other side are technologies that are reshaping the economics of production and distribution, contributing to phenomena like the growth of the Long Tail.

As in the era that Chandler profiled, this new wave of technology may lead to the development of a new generation of large enterprises. The dynamics described by Chandler favored significant economies of scale, especially in production. This new wave of technology favors significant economies of scope for customer relationship businesses. These businesses can become more helpful and create more value when they broaden their relationship with any individual customer and when they broaden the number and diversity of customers served. Unbundling of businesses may in fact be a necessary precursor to significant rebundling of enterprises focused on one of the three business types mentioned earlier. The one business that is likely to fragment over time is the product innovation and commercialization business. As Langlois points out, “industrial structure is an evolutionary design problem” and, in a period of accelerating change, we are likely to see very innovative new firm and network designs emerge.

The firm will certainly not go away during this next wave of restructuring. As JSB and I argued in The Only Sustainable Edge, though, the rationale for the firm will certainly morph significantly. For the past century, large firms have justified their existence based on their superior ability to economize on interaction costs. Now, firms will only be successful if they can deliver on the potential to accelerate capability building and the talent development of their employees. This is one of the key drivers of the unbundling process at play – a growing number of executives are beginning to realize that they cannot get better faster unless they focus more tightly on one of the three business types and shed the other businesses.

This is not just an abstract theoretical issue. As I have suggested in earlier postings here and here, the forces re-shaping our business landscape are creating significant opportunities for wealth creation for those who focus on the creation of customer relationship businesses. Those who fail to understand the imperative to unbundled are likely to destroy significant economic value. A clear view of the likely trajectory of market and industry structure evolution is essential to make the most effective near-term moves. The FAST strategy methodology provides a helpful toolkit in navigating through this turmoil.

Comments

It all boils down to the golden rule on the front line. The sales clerk and receptionist are the major representatives of the company.

But retailers still do not enforce building relationships with customers and politely meeting needs. The IPG (items per guest), sales plan, shrinkage quota, and other sales management goals are far more important, while the customers are repulsed from the dollar signs in the sales shark eyes.

Hagel-san, Thank you your new theory of the Organizations & Market.
I thinks the moduled-business strategy to make U.S. taking the lead for these about 30 years brought about big success.
Specifically, it thought that it brought about a standing result about the destribution industry and IT (Information technology ).
Surely, it expects that it is the part where Hegel is pointed out(GE).
As for the methodology which was introduced last, it much more feels that it is very wonderful that the KAUFMAN Professor in Oxford University analyzes a Innovation Function Analysis.

Thanks for this most stimulating information which I learned of through Value Networks. I offer practical tools to facilitate the sort of changes you and Professor Langlois are identifying. There is some background on my website and I would be happy to send to those interested a copy of a thirteen page paper on the Integrative Improvement Institutes Project that seeks to diffuse, refine and implement Integrative Improvement: Sustainable Development as if People and Their Physical, Social and Cultural Environments Mattered.